Macquarie's worsening performance and lacklustre return on equity is the inevitable result of a business that has lost its primary competitive advantage.
Macquarie’s recent woes, which yesterday culminated in a 25% earnings downgrade, surprised many including, it appears, many Macquarie staff. But the bank's worsening performance and lacklustre return on equity is the inevitable result of a business that has lost its primary competitive advantage. The Macquarie machine excelled partially on the basis of fees generated from captive satellites -- it was its "Macquarie Model" that turned the bank into the "Millionaire’s Factory" in the early-to-mid-2000s and it was the death of that model, coupled with the fallout from the global financial crisis, which has led to Macquarie falling out of favour with investors.
It should be noted that this view isn’t accepted by all -- including, ironically the architect of the Macquarie Model and the bank’s current CEO, Nicholas Moore. The Financial Review’s
Chanticleer columnist, Tony Boyd, stated today that:
The specialist funds were important to Macquarie in the boom years but their impact should not be overstated. In 2007, they delivered 12 percent of operating income or about $857 million. Their contribution peaked in 2008 at 19 percent of operating income or $1.6 billion. The contribution slipped back to $770 million in 2009 and $663 million in 2010.
[Nicholas] Moore is constantly frustrated by the focus on the specialised funds business. He is often heard to ask internally, "Why am I spending 90 percent of my time answering questions on something that is only 10 percent of income?"
Boyd and Moore’s analysis is technically correct, but in Moore’s case, perhaps distracting.
Macquarie’s fee income from its satellites, such as Macquarie Infrastructure Group or Macquarie Airports, was almost passive and more importantly, used relatively small amounts of capital (unlike say, proprietary trading) and was less dependent on third-party transactions (such as advising on IPOs or M&A activity). When the Macquarie Model was in full swing, the bank achieved a return on equity of 29.8% in 2005, 26% in 2006 and 28.1% in 2007 -- currently, its return on equity is about 10%.
Macquarie, of course, is hardly alone in seeing its return-on-equity dwindle -- well-regarded peers such as Goldman Sachs and Morgan Stanley have suffered a similar fate, while others, such as Merrill Lynch, Bear Sterns or Lehman Brothers fared far worse. But for Macquarie, until investors finally tired of its model of charging enormous fees to captive satellites, it had a competitive advantage that most competitors lacked, a near risk-free income stream from captive satellites.
Unlike proprietary trading (which is volatile and capital dependant) or M&A or equity capital markets advisory work (which is largely captive to market forces), the Macquarie Model demanded that satellites pay extraordinary base fees and financial advisory fees to Macquarie almost regardless of their performance. This was largely because the management fee paid by the likes of MIG and MAp was based on the satellites’ enterprise value (which is roughly the sum of their debt and market capitalisations) rather than purely on their actual performance.
For example, in 2008, Macquarie Airports annual report noted that it paid Macquarie management, performance and advisory fees of $162 million, Macquarie Infrastructure paid Macquarie fees of approximately $80 million. Macquarie also received millions of dollars in fees from Macquarie Media and its other unlisted satellites. For investors, this fee stream was almost guaranteed -- Macquarie had (largely confidential) management agreements with it satellites that virtually insisted that they use Macquarie as their financial adviser for transactions.
While Macquarie also made (and to a lesser extent, still makes) substantial earnings from its Treasury Group and its advisory businesses, these groups are largely dependant on market forces and investors will be more wary of the sustainability of those earnings.
Macquarie’s share price at this morning was $34.51, well below its peak of $98.64 reached in 2007.